Global Economics

Zhejiang Province: A Free-Market Success Story

China's Zhejiang and Jiangsu provinces seem similar, but household income in entrepreneurial Zhejiang shows an economic model to be followed

"All our indicators are better than those of Ningbo [in Zhejiang province], except per capita income," said Wang Mang, then-mayor of the city of Suzhou in China's Jiangsu province, in 2004. He was contrasting the performance of two well-known provinces in China, Jiangsu and Zhejiang. These two provinces, often lumped together in China and referred to as Jiang-Zhe in Chinese, on the surface look remarkably similar. Both are coastal: One is located north of Shanghai (Jiangsu) and the other south (Zhejiang). Both are rich: Zhejiang and Jiangsu rank as No. 1 and No. 3, respectively, in per capita gross domestic product in the country. (This calculation excludes Beijing, Shanghai, and Tianjin.) Both have grown very fast, averaging around 10% GDP growth annually in the past 30 years.

Look a bit closer, though, and the differences between these two provinces will manifest themselves. The former mayor of Suzhou touched on one difference: Compared with Zhejiang, Jiangsu has everything on its side—foreign direct investment, high-tech industrial parks (with heavy support from another FDI-heavy economy, Singapore), bank loans, and massive investments—except for the thing that matters the most, per capita GDP. In fact, other measures would show even bigger differences between the two provinces. The per capita household income, which measures the actual income received by Chinese households, is much higher in Zhejiang than in Jiangsu. Zhejiang households also have larger asset incomes—the incomes received from savings, property transactions, and leases. An average urban resident in Zhejiang earned an asset income 3.4 times that of his counterpart in Jiangsu.

There is another difference between them: Both provinces are rich, but they are rich for different reasons. To put it simply, Zhejiang is rich because it has grown faster; Jiangsu is rich because it has always been rich. In 1980, Zhejiang was ranked No. 7 in the country in terms of per capita GDP, compared with Jiangsu's No. 3 position. Zhejiang's catch-up story makes its performance doubly impressive. These differences are not mere statistical abstractions. They have real welfare implications. In 1990 an average resident in these two provinces had a roughly identical life expectancy at birth: 71.4 years in Jiangsu and 71.8 years in Zhejiang. In 2000 the gap increased: 73.9 years in Jiangsu and 74.7 years in Zhejiang. An average rural resident in Zhejiang consumes and owns more telephones, PCs, color TV sets, and cameras than his counterpart in Jiangsu. He also lives in a bigger house.

"The Other Path"

What sets Zhejiang apart from Jiangsu? Two words: indigenous entrepreneurship. In Peruvian economist Hernando de Soto's seminal book, The Other Path, De Soto documented the barriers to indigenous, small-scale entrepreneurs in his native country and the massive, self-inflicted harm to a poor struggling economy because of policies repressing indigenous entrepreneurship. There are many regions in China that resemble de Soto's Peru. Jiangsu is one of them and so is a city widely admired by Westerners—Shanghai. In these regions, the reigning economic model is to court, woo, and placate foreign investors while imposing onerous regulatory and financial constraints on indigenous entrepreneurs. The rationale—to the extent there is one—is that foreign investments bring technology and management knowhow whereas indigenous entrepreneurship is shabby and low-tech is to be shunned. For complex reasons, this technocratic view of economic development has never been a prevailing ethos in Zhejiang.

Jiangsu and Zhejiang represent two contrasting development models in China, a phenomenon first noted in 1986 by Professor Fei Xiaotong, China's most prominent sociologist. The Zhejiang model is characterized by a heavy reliance on private initiatives, a noninterventionist government style in the management of firms, and a supportive credit policy stance toward private companies. Probably the most famous product of the Zhejiang model is Wenzhou, a city in southern Zhejiang province that today accounts for a disproportionate share of rich entrepreneurs, asset owners, and China's manufacturing prowess.

Although Wenzhou and Zhejiang represent the triumph of laissez-faire, broad-based, entrepreneurial capitalism, many outside analysts fail to appreciate why China should adopt free-market economics rather than retaining state-owned monopolies and state interventionism. Western observers and many inside the Chinese government focus on a narrow set of economic indicators. Specifically, they track economic performance by GDP data. In terms of GDP performance, the differences between Zhejiang's economy and the more statist economies of Jiangsu and Shanghai seem to be minor. Zhejiang outperformed these two regions in GDP performance but not by a large margin. So does it matter that China failed to embark upon "the other path?"

Breaking Down the Numbers

Economics, John Stuart Mill famously stated, is the study of "the sources and conditions of wealth and material prosperity for aggregate bodies of human beings." "Aggregate" is the key operating word here because it gets to the heart of why economic growth matters. Growth is important because it improves the welfare of the majority of the population. It is not sufficient that growth only benefits a few elitist members of the society. Here's where the difference between a bottom-up, entrepreneurial economy and a statist economy looms large.

Let me contrast Zhejiang with Shanghai. Shanghai has some exalted GDP numbers. For example, in 2004, Shanghai's GDP per capita was 55,037 yuan (about $6,880). This was 5.2 times China's GDP per capita. These data, however, are extraordinarily tricky. GDP per capita is often loosely referred to as income per capita. That phrase leaves the impression that an average Shanghai resident earns an income close to its GDP per capita, i.e., 55,037 yuan. Many foreign firms, for example, use GDP per capita data to design sales strategies in their regional marketing plans. But this assumption is deeply flawed.

There are two ways to disaggregate GDP data. One is the expenditure approach, under which GDP is disaggregated into consumption, investment, government spending, and net exports. The expenditure approach is the most common method by which GDP data are reported for China and for other countries. The alternative approach is the income approach, under which GDP is divided into the following components: labor income (wages and benefits); capital income (business profits, interest, and rent); depreciation; and taxes (income to the government). Depreciation is otherwise known as consumption of fixed capital, and it refers to the amount that businesses set aside to replace worn-out structures and equipment. Calculations of the income components of GDP often require removing the depreciation amount from GDP. GDP minus depreciation becomes the net national product.

The other three components of GDP represent income accruals to the three main players in an economy—labor, capital owners, and government. This decomposition of GDP immediately illustrates the fallacy of the common assumption: GDP per capita of 55,037 yuan in 2004 does not at all mean that an average Shanghai resident earned 55,037 yuan. The 55,037 yuan was shared among labor, capital owners, and government. Importantly, it matters how the GDP is shared among them.

In 2002 (the latest year for which such data are available), employee compensation comprised 41% of Shanghai's net national product. This is a remarkably low ratio. In the U.S., the labor income and proprietors' income together typically exceed 70% of the net national product. Employee compensation comprised 53% of the net national product in Zhejiang, a full 12% higher than in Shanghai. The two regions have almost identical shares of corporate profits, about 30%, which implies that the key difference between the two is the income accruing to the government. For Shanghai, the ratio is 28.9%; for Zhejiang, it's 17.4%.

The upshot of this analysis is that an average resident in Zhejiang captures 10% more of each increment in economic output than does his counterpart in Shanghai. He is 10% richer, but his government is 10% poorer. Therein lies the fundamental difference between an entrepreneurial economy and a statist economy: The former makes the economy grow but also improves "material prosperity for aggregate bodies of human beings;" the latter increases GDP but allocates most of the gains to the government.

Shanghai vs. Zhejiang

Shanghai itself is rich but an average Shanghainese is not. This is the price and the cost of a statist economy. A detailed examination of GDP and household income data show that these two data series behave in a systematically different fashion between Shanghai and Zhejiang. In the 1990s the ratio of Shanghai's GDP per capita relative to the national means continuously rose, from 4.7 in 1999 to 5.2 in 2004, indicating Shanghai gained relative to the rest of the nation in GDP terms. The same ratio rose in Zhejiang as well, from 1.8 to 2.3, but that's where the similarity between them ends. In Shanghai, household income—again relative to the country as a whole—actually declined, from a ratio of 1.87 in 1999 to 1.77 in 2004. In Zhejiang, household income growth kept pace with its GDP growth. The ratio rose from 1.44 to 1.54.

This comparison gets to the essence of entrepreneurship. Entrepreneurship not only contributes to GDP growth but also to the income growth of average people. Statism, while maybe effective in producing impressive GDP numbers, does not make income grow that much. Between 1999 and 2004, Shanghai experienced a massive construction boom and exploding GDP growth, but an average Shanghai resident actually lost relative to the rest of the country. In Zhejiang, GDP also grew quickly but so did the income of average Zhejiang residents.

It is high time to dig into data beyond GDP performances in order to distill the correct policy implications. Should China have adopted de Soto's "other path," it would not only have impressive GDP numbers to showcase but also distributed growth dividends, faster income growth, a more solid base of domestic consumption, and ultimately a Chinese population that reaped broad benefits. To achieve these objectives, the Chinese leadership needs to look no further than its own star province, Zhejiang.